Hedge funds can't escape the regulatory spotlight

Date: Thursday, October 19, 2006
Author: Jeremy Gaunt and Laurence Fletcher

LONDON (Reuters) - Almost out of the blue hedge funds are facing a chorus from policymakers for greater regulation, although many believe they can do it themselves and worry that new rules would cramp their style.

In the space of only a few days, hedge funds, which invest in anything from bonds and stocks to infrastructure and feature films, have faced calls from those alarmed at potential systemic risks to global markets.

Commentators have largely welcomed the fact that the disaster at U.S.-based Amaranth Advisors, which suffered a $6.4 billion (3.4 billion pound) loss, the biggest hedge fund loss ever, in September after wrong-way energy bets, or recent losses by Vega Asset Management, have caused little market disruption.

It may be, however, that this is a reflection of current market conditions and it has not stopped demands for greater, but as yet undefined, regulation to prevent a similar, but much more devastating event shaking global financial stability.

"We should not conclude that it will be as smooth and easy next time -- and of course there will be a next time," Bank of England Deputy Governor John Gieve said on Tuesday, referring to Amaranth. "If we face a financial crisis in the next few years we are almost bound to find some hedge funds at or near the centre of it."

Germany, meanwhile, is insisting that it will raise the issue of hedge fund transparency at the meeting of the Group of Eight industrial nations next year.

European Central Bank President Jean-Claude Trichet last week said international regulators were fairly close to reaching an agreement on tighter rules for hedge funds.

In the U.S., the world's biggest centre of hedge fund management, Charles Grassley, chairman of the powerful U.S. Senate Finance Committee, said on Monday he is alarmed at the risks posed by hedge funds to pension funds.

LIQUID PROTECTION

The irony behind the latest burst of concern about hedge funds and financial stability is that the one recent event that might have sent ripples across markets -- Amaranth -- failed to do so in any significant way.

Market reaction was minimal and there was little of the turbulence that followed the collapse of hedge fund Long Term Capital Management (LTCM) in 1998.

This was put down in part to U.S. monitoring systems set in place after LTCM, which, despite Grassley, U.S. officials say should be enough.

But there may also have been some different, market-related, factors at play.

BoE's Gieve touched on the issue in his speech, noting that whereas LTCM's troubles were triggered by Russia's debt default, which sent a shock across a wide range of markets, Amaranth's were set off by a less stressful event.

A fall in natural gas futures prices, he said, was a benign factor for growth and inflation. In other words, a healthy economy can protect against negative shocks.

"Unless you have broader macro issues that support a negative tone ... the underlying market impact (of a hedge fund collapse) could be mitigated," said James Fairweather, chief investment officer at investment boutique Martin Currie.

There is currently plenty of liquidity in the market and many are seeing extremely low volatility, factors that should help limit the impact of those that fall by the wayside -- as about 40 percent of start ups are currently doing.

Sander van Stijn, senior portfolio manager with Fortis Investments' funds of hedge funds, said ample liquidity may have allowed investors to absorb Amaranth's losses quite easily.

The problem comes when the market is different.

"You never know what will happen during the next liquidity crisis," he said.

HEALING THEMSELVES

Although their name implies reducing risk by hedging out factors such as movements in the overall market, hedge funds are seen by many as highly risky, free-wheeling products.

However, while some hedge funds believe increasing regulation in some form or another is inevitable, many believe the systems they have in place are sufficient.

Edward Bonham Carter, joint chief executive of Jupiter Asset Management, which runs traditional and hedge portfolios, said hedge funds should be subject to more regulation but said the industry was already moving in the right direction.

"The bigger hedge funds in the U.S. and in the UK are starting to comply with best practice and I expect to see the industry move that way," he told a meeting of the Securities and Investment Institute.

But many see the danger of government overreaction, which could put a chill on new start-ups and cramp the industry's style.

"There is always the possibility of over-regulation," said Simon Wilson, head of marketing at Old Mutual Asset Managers, which runs around $2.5 billion in hedge fund assets.

He said the growing trend for large institutions to invest in hedge funds is bringing with it its own focus on oversight and corporate governance.